Upside risk is the reward that people are talking about when people say “risk versus reward”. Here’s how I think about upside risk in my financial independence campaign.
How do you define upside risk?
Upside risk is risk that a decision made or chance taken actually goes the way you hoped, and you gain a benefit.
For example: you’re late for a bus. You run across a field to catch it, instead of walking around the field on the footpath. The next bus is in 30 minutes, so you’re hoping that the benefit is not having to wait for 30 minutes.
Upside risk should be measurable. In the above example, the time you’ve saved compared to waiting for the next bus is the measurable part.
The opposite: downside risk
Most people think of risk as the chance that bad stuff is going to happen to them. That’s called downside risk.
For example: you run across the field for that bus, but you might trip over into the mud while doing so, or you might be sweaty when you get to the bus so you are noticeably smelly when you arrive. Or, you know, someone might see you.
Fear of upside risk
It’s quite easy to have confirmation bias when you get a boost from taking risks that pay off. That’s when you believe that something is true, so you use every bit of evidence or coincidence to make you more sure of this belief.
For example: you spend £100 on Dogecoin. Elon Musk releases a pop video about it, starring Cardi B, and it shoots up in price. You sell the Dogecoin for £1,000.
Great upside! Aren’t you glad you took a chance?
Now that you’ve been rewarded, you decide to go all-in with your winnings on a crypto token called NOTASCAMCOIN, without doing any background research. When it turns out to be a scam, as it fully admitted in its own white paper and its own website, you are surprised. How could this happen?!
You believed that ropey crypto was a good investment, no matter what. Your belief was confirmed by your Dogecoin profits, so you had zero fear in buying that obvious scam coin. Confirmation bias in action.
There are reasons to believe that successful reward for taking risk reinforces something called “optimism bias“. Optimism bias is basically the belief that you’re an immune to bad stuff happening to you. Humans generally suffer from something called “confirmation bias“, which is the phenomenon that you tend to place a lot of weight on evidence that supports something you think already.
So, logically, if you’re optimistic that you tend to be a lucky person, each risk you take that turns out well will presumably reinforce this belief.
This is a large part of why when most people think “risk management”, they think of reducing downside risk. This McKinsey report on risk management in banks certainly focuses on the downside.
It’s probably accurate for me to say that most people fear upside risk getting out of control and fear downside risk in general. However, interestingly, fear of realising a downside risk might also be an inducement to take bigger risks, without making a sensible comparison of upside vs. downside.
Anyway, the important point I want to make here is that most people get a fear response to risk. They then seek to mitigate downsides, but generally don’t consider the positives.
It’s quite rare to see people in the financial independence community talk about there being an upside and it’s even rarer to see anyone try to balance upsides against downsides.
Financial independence and fear
One of the things I’ve seen on the r/FIREUK subreddit is a climate of fear. Now, ironically, this might be my confirmation bias noticing more fear-based topics than benefit-focused topics on the forum, so feel free to disagree.
Assuming I’m right though, I’ve notice the following fear-based ideas on the sub-Reddit, time and time again:
- “I want to be financially independent so I don’t need to worry about being sacked”.
- “The 4% rule is too optimistic, I think I’ll invest and go for a 3% rule, but even that’s optimistic.”
- “Stick it out with the job you hate, don’t quit to set up your business idea.”
Now, these are all reasoned. I’m not even going to try to disprove them, because that’s not the point of this post. However, let’s say we switched these to focus on the upside:
- “I want to be financially independent so that I can try lots of new things and see what I like to do.”
- “If I plan off the 4% rule, I know I can retire from compulsory work earlier. With that space and time, I can work out how I want to earn extra money if I need it.”
- If I quit this job, I can try out that business idea and see if it works. I might be able to build an asset for myself and accelerate my journey to financial independence.”
Does the last list look like something you’ve seen on a FIRE forum?
No, I didn’t think so either.
I’m pretty sure the financial independence campaign tends towards risk aversion. That’s not necessarily a problem, but I’m of the opinion that we should think about upside risk more when working towards financial independence.
In favour of upside risk in financial independence
As I’m hoping will be obvious, anything taken to an extreme will be, um, stupid.
Without becoming a turbo-optimist, here’s my argument in favour of considering upside risk in all parts of the financial independence campaign.
Mindset
If I consider upside risk when making decisions, I am more likely to remain open-minded to new opportunities.
Recently, I received a selection of (nice!) comments and messages about being a financial independence blogger who hodls crypto (no, not a typo). I’ve been quite open about it: here’s my second post on using stable coins, here’s my post on Anchor protocol, here’s my side hustle post on yield farming. I’m sure there are a couple more.
In fact, all of my posts on side hustles come from me seeing the upside risk of putting a bit of capital into a little venture.
I estimate that I’ve earned an extra couple of thousand pounds tax-free from various side hustles over about two years. They’ve also been hobbies in their own right, often saving me the money I would’ve spent on entertaining myself some other way. How’s that for upside?
I think I mentioned in my 2022 campaign plan that I’m also career changing into law. That started with an Open University degree and investing some of my leave time into summer schools, then a big commitment to do the Legal Practice Course and basically just side hustle for a year.
Why career change in my 30s?
Well, the upside risk is that I might double my previous salary next year.
I encourage everyone to have a mindset that considers upside risk, even if you don’t follow through on every opportunity. You might find that you create new opportunities for yourself.
Strategy
If I consider upside risk when developing a strategy for my financial independence campaign, I can plan for successes as well as failures.
For example: my house’s value shot up this year. We hit 60% Loan-To-Value on our mortgage much quicker than expected, so we’ve now gained the benefit of £220-ish per month of additional investible income.
We already had a plan for this to happen, because we’d considered that house prices might increase and we were on the lookout for it. There wasn’t much discussion about “do you think we should keep overpaying..?”. We simply stopped, because we already had a plan for where our money would go next.
If we didn’t consider upside risk, we’d never have stopped making mortgage overpayments.
Sure, the house might be paid off, but there would have been no thoughts about the opportunity cost of overpaying for limited benefit when we could be investing.
I’d encourage everyone to plan for upside risk, so that you can make the most of opportunities that your assets create for you.
Portfolio
If I consider upside risk, I will have the courage to invest in equities when market outlooks are gloomy. This investing strategy paid off for me over the early COVID-19 lockdowns, lowering my average buying price.
If I didn’t consider upside risk, I would never have committed resources to crypto or start-ups.
OK, so it was a while ago, but I made something like £9,000 profit from a £300 investment in (then) start-up Brewdog that I made back in 2010. I’ve also made paper gains of something like 300-400% from crypto over the last eighteen months, which I’ve mainly put into stablecoins for now.
Yes, the high risk investments could have all failed, but so far they’ve pushed me about 2 years ahead of where I could have been. The caveat is that I don’t put too much into either start-ups or crypto, such that if they all fail I will still retire early, just maybe a couple of years later than I’d hope.
I’m not going to encourage anyone to squeeze these types of asset into their portfolio. The risk involved in them is hard to quantify. It’s possible that all of them fail.
Just because I do something, doesn’t mean you should! Don’t trust your future to a random on the internet, even if they have an awesome blog with great pictures.
I’m simply suggesting that you consider investing in things outside of the classic “all in ETFs” bubble.
Maybe you see a house in disrepair that you could throw some money at to create a nice buy-to-let; maybe you invest your time into setting up a business doing website building; perhaps you buy and flip websites.
Whatever.
Just consider keeping an open mind to things that might go well in your portfolio of assets.
Final thoughts
While I completely understand fear of failure that comes with any risk – financial or otherwise – I’d encourage everyone to at least consider upside risks in every opportunity.
Who knows? Taking that calculated risk might just get you to financial freedom sooner.
